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Just when you think the sky is falling, the storm clouds begin to lift. The rancorous budget battles in Washington, the U.S. Treasury-bond downgrade and fears of a double-dip recession, which knocked the stuffing out of the U.S. stock markets, are all so last summer. A short-term resolution to the European debt crisis last week lightened the burden, as well. The Dow Jones Industrial Average, which sank 16% from July through early this month, rebounded 15% through Thursday. The Standard & Poor's 500, which fell an equal amount, has rallied back even more. At 12,209 and 1285, respectively, the Dow and the S&P are now both up on the year.

In the face of such extreme volatility, the 121 portfolio managers responding to Barron's biannual Big Money Poll have tempered their expectations for the coming year but are optimistic, nonetheless. Roughly 52% of managers describe themselves as very bullish or bullish on the market through next June. Granted that's down slightly from the 59.5% who were bullish in our spring survey ("Watch Your Step!", April 25). But the results are far from bearish, considering that another 31% of respondents consider themselves neutral on the market. Their confidence is even more impressive, given that we e-mailed out the survey on Sept. 27, as the market was reaching its lowest level in nearly two years.

Roughly 52% of respondents described themselves as bullish or very bullish, down from 59.5% in April.
Scott Pollack for Barron's

Those who consider themselves bullish see the market rising, but not in spectacular fashion. The bulls expect the Dow to finish the year at around its current level and rise 5% by next June, to 12,773. A similar gain in the S&P would boost the index to 1343 if the bulls in our survey are right.

"The rays of sunshine are really in the valuations," says James Hardesty of Baltimore-based Hardesty Capital Management, which has $725 million under management. The forward price/earnings ratio on the S&P 500 is 12.1, well below the average over the past 10 years of 14.9, according to FactSet. If the S&P returned to the average multiple, the index would be 23% higher.

THE MARKET'S COMPELLING VALUATION did not escape portfolio managers. Of those responding to last month's survey, 61% felt that the U.S. stock market is undervalued, 26% considered it fairly valued and only 13% saw it as overvalued. Along the same lines, 69% of portfolio managers thought that the market was likely to rally by 10% or more in the next six months.

Stocks look particularly attractive because profits have risen sharply. Next year earnings per share for the S&P are expected to to rise 11%, to $108, according to Wall Street estimates.

Granted, almost 80% of Big Money responders believe those estimates will come down by the end of the year, but if they fall modestly, the market could still perform well, argues Arnold Schneider, the chief investment officer of Schneider Capital Management, a Wayne, Pa., investment firm with $2 billion under management.

Stocks also look attractive because the alternatives look so bad. Bonds have rallied to ridiculously low levels and are at the tail end of a bull market that spans almost three decades. The S&P 500's earnings yield -- or the $108 in earnings divided by the price of the index -- is 8.4%. That falls to 7.6%, if 2012 earnings come in 10% lower than expected. But it would still be far superior to the 2.3% yield on 10-year Treasuries or the 4% offered on investment-grade corporate bonds.

The same trend holds true for the broader market. The overall S&P 500's dividend yield is 2.03%, on par with the 10-year Treasury yield of 2.3%, according to Standard & Poor's.

"When stocks rally, people will take money out of bonds and put it into equities," says Quoc Tran, portfolio manager at Lateef Investment Management, which oversees $4 billion.

When asked which asset class would offer the best returns over the next six months to a year, 63% of money managers said equities would provide the richest rewards, and 17% pointed to precious metals or other commodities. Only 6% said fixed income would be the best performer; 5% said cash.

Dour expectations for debt and cash returns aren't prompted by fears that inflation will spike. Only 26% of respondents worried about inflation over the next year. In fact, investors were almost equally split between fears of inflation; deflation, 18%; and stagflation, 28%. None of the above (or continued low inflation) was predicted by 28%.

Inflation is less of a concern now that many commodity prices have fallen, including that of crude. Portfolio managers are convinced that oil, now at $93 a barrel., will fall to $89 in a year.

With expectations for tame inflation and the Federal Reserve bent on keeping rates low, it's not surprising that more than 70% of respondents thought the yield on 10-year Treasuries would remain between 2% and 2.5% over the next six months. But Treasuries are even less attractive because inflation, as measured by the consumer-price index, is roughly 3.9%, resulting in negative real returns.

Yields on fixed income are artificially low because of actions taken by the Fed, notes Scott Schermerhorn, principal at Granite Investment Advisors, a Concord, N.H.-based shop that manages $500 million. Without the Fed manipulating the market, the yield on the 10-year Treasury would be closer to 3.5% to 4%, he estimates. While those rates may not be high on an absolute basis, a return to those levels would drive Treasury prices down as much as 14%.

CERTAINLY NOT EVERYONE is bullish on stocks: 17% of managers consider themselves bearish or very bearish. Among those with dour expectations, the average target for the Dow is 10,789 by year end and 10,757 by June, for a 12% loss. The same group sees the S&P 500 falling 13% by next June.

Caryn Zweig, the chief operating officer at Abner, Herrman & Brock, which manages more than $800 million, says she's bearish because of "the abysmal lack of any catalyst that can ignite confidence, conviction and growth over the next couple of years."

There's a greater than 50% chance that the U.S. economy ends up in recession, warns Gustave Krafve, portfolio manager at Trust Co. of the Ozarks, in Springfield, Mo. Krafve, who directs a $630 million portfolio, was bullish in 2009; he now considers himself a bear and worries that there is excessive debt in the system at the government level and among individuals. "We are in a deleveraging cycle with below-trend GDP growth," he says.

Only 12% of portfolio managers said they thought the economy will dip back into recession over the next year; 51% said that fate was somewhat likely; and 37% believed the occurrence was not likely.

Most bulls and bears agree that deleveraging still has years to go and will constrain economic growth. A full 75% of respondents expect annual growth of the U.S. gross domestic product between 1% and 2%. A smattering, some 15%, see growth of 2.5% or more; a rare few, 4%, see GDP declining. On Thursday the first reading of third-quarter gross domestic product came in at a 2.5% increase, matching market expectations.

With most expecting slow growth, it's not surprising that there's a lot of uncertainty about what the Federal Reserve will do next. Poll respondents are almost equally divided on the matter: 58% of portfolio managers thought the Fed would not launch a third round of quantitative easing -- purchasing Treasury securities in an attempt to stimulate the economy -- in the next six months, and 42% thought the Fed would do another round of easing.

Although PMs were split on what the Fed will do, they most definitely, at 88%, thought the Fed should not do anything. And ironically, among those who expected the Fed would act, a full 78% thought those actions would not boost the economy -- certainly not a ringing endorsement of our central bankers.

"The economic impact of further QE will be minimal," responded one portfolio manager. "In order to lay the foundation for future growth, the U.S. must work through the deleveraging process. Policy actions like QE only extend the time that it will take to reach firm economic footing."

Another manager had mixed views on the success of the first two rounds of stimulus. "They stimulated the stock market and did little to set the foundation for organic growth of the economy. Put people back to work and the economy will stabilize and grow." Others worried about the inflationary effects of quantitative easing and the negative impact on the dollar.

"In general, the Fed needs to let the markets heal themselves, and step aside," wrote one PM, echoing the thoughts of a number of others.

OVERSEAS, IT'S THE EUROPEAN drama that's capturing portfolio managers' attention. Investors are jittery that a misstep in handling the debt of the overleveraged southern members of the European Union could result in an international banking crisis. "Despite last week's rally, the market is still pricing in some odds of a Lehman moment," says Schneider.

Almost all of the folks responding to the survey -- 96% -- believed that there would be a sovereign-debt restructuring in Europe within 12 months. Of those, 100% said Greece would restructure, and 35% believed Portugal will do the same. Only 16% saw a similar fate occurring in Italy, and even fewer, saw a restructuring in Ireland, 12%, and Spain, 13%.

"Greece [will be] the first of a few in the next five years that will have to do some sort of restructuring," Krafve of Trust Co. of the Ozarks, correctly predicted.

Even if restructurings occur, a large majority, 88%, think the European Union will survive the tumult. It might have fewer members, they said, but it will survive. "Having a monetary union without a fiscal union was questioned since its inception. Now that we have had stress in the system, it's becoming more apparent that it's a flawed system," wrote one respondent. "Perhaps [the EU] partially survives with the countries that intend to meet and adhere to the EU's stated criteria. In hindsight, admitting countries that did not meet their tests, such as Greece and Italy, was a big mistake."

OVER THE NEXT YEAR, politics will take center stage as the 2012 U.S. presidential election approaches. Republican candidate Mitt Romney may be running neck-and-neck with Herman Cain now, but among the Big Money crowd, Romney's a winner. More than 80% of respondents thought he'd capture the Republican nomination. Only 8% said they thought Rick Perry will get the nod.

Granite Investment Advisors' Schermerhorn would actually like to see Cain win because he likes the idea of a flat tax. But he doubts that the idea would ever be implemented because legions of lawyers and accountants have a vested interest in our current arcane system.

If the Big Money results are on target, Romney is likely to be president-elect in a little more than a year; 70% predicted whoever won the Republican nomination would defeat President Obama.

"No president [in recent history] has ever won re-election with unemployment this high," observes Lateef's Tran. Adds Schneider, "President Obama has a steep uphill climb. He owns the economy, and it's not going to revive over the next 12 months."

THE MARKET WAS SO DEPRESSED earlier this fall that just a little bit of positive news lately seems to have pushed stock prices higher. Half of our respondents said progress in resolving the European Union's financial problems would send shares northward. And a quarter of those responding cited improved economic data or higher employment as news that could spark a rally.

Our money mavens are well aware that their clients, too, are feeling the blues. Indeed, it has been a punishing 10 years. A full 83% of portfolio managers say that their clients are bearish about stocks -- perhaps an excellent contrarian indicator? "Investors were cautious, so it did not take a lot of good news to get things moving," says Dave Daglio, portfolio manager for the Dreyfus Opportunistic Midcap Value fund and the Dreyfus Opportunistic Small Cap fund, with a total of $2 billion under management.

The good news for the market is that a full 90% of portfolio managers said they expect to be net buyers of stocks over the next six to 12 months. Conversely, allocations to bonds and cash are set to drop.

As our portfolio managers look at which markets around the world they should invest more in, they seem to be finding home sweet home a good bet. More than half said the U.S. would boast the best returns in the next six months to a year; 13% said Brazil's market would be the best-performing market; and 8% thought either Europe's or China's markets would fare the best.

In fact, the love affair over the past decade with emerging markets and China may be cooling: 46% of the respondents said they'd allocate more to U.S. equities, while only 32% said they'd allocate more to the emerging markets, and 12% will be betting more on the developed overseas markets.

When looking at where to invest within the U.S. markets, 68% of portfolio managers thought large-cap stocks would post the best performance in the next year. Only 17% thought it would be mid-caps and even fewer, 15%, favored small-caps.

But Dreyfus' Daglio thinks the consensus could be surprised by small-cap outperformance if the U.S. economy either skates by without entering a recession or if it hits a mild recession. He notes that small-caps have less exposure to Europe and to the emerging markets, which might slow more than expected. He adds: "The U.S. is becoming the best house in a bad neighborhood."

Two of the managers we spoke with said Qualcomm is underappreciated. The company gets a royalty payment on every smartphone sold in the world, and it makes chips in e-readers as well. Worldwide cellphone sales rose 32% last year while smartphone sales jumped 72%, according to Gartner. The market share for smartphones should continue to climb.

"With that as a tail wind, it doesn't matter if U.S. GDP is 1% or 2%," says Tran of Lateef. Qualcomm will increase earnings much faster than the economy's growth rate, he says. Qualcomm, which recently traded at $52, is one of the firm's 15 holdings. The company is expected to report $3.18 a share in earnings for the fiscal year that ended in September, and $3.48 in FY '12. He says that if you back out the $13 a share in net cash on its balance sheet, shares trade at 11.6 times this year's estimates. Qualcomm will report year-end results on Wednesday.

Zweig also looks for companies benefiting from trends that will lead to market and industry outperformance. She also likes Qualcomm. And she cites Apple as an example of a "specific company doing specific things wonderfully, and then there are other companies in the same sector that can't get out of their own way."

Schneider likes sectors where earnings have not returned to pre-recession peaks. One of his favorite areas right now is the thermal-coal industry, which benefits from the demand for electricity around the world.

Demand for coal, boosted by the growth in India and China, will grow in the high- single-digit percentages, and it's difficult for the supply chain to keep up with that growth, Schneider says. In other words, the mines, railroads and ports needed to find and transport the coal won't be able to keep pace with demand. There was a surplus of coal in the recession. That has been drawn down, and next he sees prices increasing. His favorite names in the sector:
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(CLD) and
Arch Coal aci -0.2041649652919559%Arch Coal Inc.U.S.: NYSEUSD0.9776
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(ACI), which also topped the list of companies portfolio managers liked.

Another sector where earnings haven't returned to peak levels is housing. About 30% of all publicly traded and private home builders have gone bankrupt, and the survivors have managed to be profitable when new home starts are a third of what's normal. Some of the names Schneider owns:
NVRnvr -0.375186846038864%NVR Inc.U.S.: NYSEUSD1332.98
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:
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5434955729.48456
Dividend Yield
N/ARev. per Employee
1126650More quote details and news »nvrinYour ValueYour ChangeShort position
(NVR) and
Toll Brothers tol 0.6375924509053813%Toll Brothers Inc.U.S.: NYSEUSD39.46
0.250.6375924509053813%
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:
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P/E Ratio
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6886295576.81945
Dividend Yield
N/ARev. per Employee
1177540More quote details and news »tolinYour ValueYour ChangeShort position
(TOL), both of which will turn a profit this year.

"The worst of the housing news is behind us," says Daglio, who believes the best values are in deep cyclical names. Another area he favors: makers of trucks and truck parts.

The financial sector remains unloved, even among this crowd of investors who are typically willing to buy out-of-favor names. Almost a third of managers felt the financial sector would be the weakest performer in the next year.

"We still think it's very hard to understand what the assets are worth" and what the earnings potential is at financial companies, says Daglio. Pending regulation means it's unclear how much leverage financials can take on to boost earnings. In fact, he adds that "every company we speak with would like more visibility into the regulations that are forthcoming."

Despite a strong performance this year and last, the consumer-cyclical space continues to be on the outs. Among the sectors expected to post the weakest performance, consumer cyclicals are cited (12%), right alongside basic materials (13%) and utilities (16%). Looking at recent consumer-confidence numbers, this result seems reasonable. Consumer confidence fell to 39.8 in October, the lowest level since March 2009.

Two areas that may be overvalued now are utilities and consumer staples. Investors fled to these stable earners during the uncertainty of this summer. But now, they're "very expensive relative to the rest of the market," says Schneider.

Perhaps the best news from the survey is that portfolio managers are beating the returns on the S&P 500, both professionally (66%) and personally (71%). Investment managers certainly can't make the market rise, but at least they can earn their fees by outperforming the market.